Central banks to call tune

Australia expected to tighten further as Fed, Europeans stand pat

By

WilliamL. Watts

A previous version of this story made an incorrect reference in paragraph 8 to interest rate expectations in Australia. The story has been corrected.

LONDON (MarketWatch) -- A round of rate decisions from across the globe this week will underscore the difference between the commodity-oriented economies that have proved insulated from the global credit crunch, and those at its core -- the United States and Great Britain.

Australia is expected Tuesday to continue leading the way toward higher interest rates, but it's not clear that major central banks will be following suit any time soon.

A faltering equity rally and rising volatility will put extra emphasis on this week's round of major central bank meetings, strategists said, with the U.S. Federal Reserve's policy statement Wednesday likely to serve as the linchpin.

On Thursday, the Bank of England must decide whether or not to extend its massive 175 billion pound ($289 billion) quantitative easing program as it wrestles with a recession that appears set to outlast other industrialized economies. The European Central Bank, which sets monetary policy for the 16-nation region that uses the euro currency, also holds its monthly meeting Thursday.

Australia in the vanguard

The RBA has little choice but to hike rates for a second time in as many months given rising inflation prospects and signs Asia's capital-expenditure cycle is in the early stage of a strong rise, said Glenn Maguire, chief Asia-Pacific economist at Societe General in Hong Kong, in a research note.

Major oil exporter Norway last week became the first central bank in Europe to tighten monetary policy. Its central bank lifted its key rate by a quarter point from 1.25% to 1.5%. See full story.

Australia's central bank is widely expected to hike its key lending rate by a quarter of a percentage point to 3.5%. Last month, it was the first central bank in the Group of 20 to begin tightening rates, lifting the key rate to its current level from 3%.

Expectations for a hike were strengthened after the Australian government on Monday boosted its growth forecast for the coming year.

The Australian dollar
C_AUD
and the currencies of other commodity-oriented countries have been top gainers as global investors as commodity prices rose and investors upped their appetite for risky assets. Also, with Australia leading the way on tightening, relative interest-rate expectations have also favored the currency.

The Aussie's recent run has left it within striking distance of parity with the U.S. dollar, although strategists question whether the run can continue even if the RBA follows through with Tuesday's expected move.

John Higgins, market economist at Capital Economics, contends Australia still has plenty of spare capacity despite having avoided the worst of the global downturn. As a result, rates might not rise as far or as fast as many expect, he argued in a research brief Monday.

Meanwhile, risk aversion has returned to the market since U.S. equities peaked last month, said Neil MacKinnon, global macro strategist at VTB Capital.

That will make this week's run of central bank decisions and pronouncements, as well as U.S. October employment data on Friday and a weekend meeting of Group of 20 officials, crucial for direction in equity and other markets, he said.

Parsing the 'extended period'

Meanwhile, the Fed is fully expected to leave its key interest rates near zero. Instead, the focus will be on the language used in the committee's policy statement.

Specifically, the idea that the Fed will eliminate the term "extended period" to describe how long it intends keep interest rates low has gained traction in the market, analysts said.

"Leaving the statement unchanged signals that the Fed will keep the flood gates of monetary accommodation open for an extended period of time, which might initially by cheered by equity markets," they said, in a research note.

The BNP Paribas strategists say a further weakening of the U.S. dollar will require a constructive bond market. Therefore, if the bond market loses confidence in the Fed's price-stability guarantees, the equity market rally will falter again, with a strong dollar serving as the catalyst.

"Bear in mind it was U.S. dollar liquidity driving markets. Hence, it will not be the RBA, ECB or even the BOE deciding which way markets will develop in the medium term," they said.

Laggard

Meanwhile, many analysts expect the Bank of England's rate-setting Monetary Policy Committee to boost its asset-purchase program by 25 to 50 billion pounds, but warn that the decision isn't clear cut.

The decision "will be a close call, and whilst we have reservations about its effectiveness, expansion of [quantitative easing] may be the path of least resistance," said Peter Dixon, U.K. economist at Commerzbank. He expects a 50 billion pound rise in the limit.

Increased quantitative easing, which centers on creating new electronic reserves that are used to purchase gilts and other assets, has tended to be a negative for sterling in the past, analysts noted.

Ideas the BOE would boost the size of the program were boosted last month, when government figures showed third quarter gross domestic product shrank by 0.4%, defying market expectations for a return to growth.

The ECB, meanwhile, is widely expected to hold its fire when its governing council meets in Frankfurt.

The central bank is forecast to leave its key lending rate unchanged at a record low 1%. The unwinding, when it comes, is expected to first center on the central bank's extraordinary measures to shore up liquidity and maintain credit flows in the euro zone.

"The ECB is under no pressure to raise the refi rate from 1%," said Mark Wall, economist at Deutsche Bank. "The question in November is, will the ECB reconsider any of the non-standard monetary policy operations? The economy and banking markets are showing signs of improvement, but we expect the ECB to play it safe and defer any exit decisions."

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